Commentary
The Bank of Canada has elected to raise its policy rate to 4.75 percent. The market in the form of the yield curve had estimated a 40 percent to 45 percent chance that the Bank would raise the key rate. Economists had put the probability at only 20 percent. Yet again the market outperforms economists.
The day before, one-year rates traded around 4.96 percent while ten-year yields traded at an eye-opening 1.64 percent below that yield at 3.32 percent. One-year rates were steady after the announcement while ten-year yields rose about ten basis points after the announcement.
Bond investors seemed shaken. The collective opinion of the market may be shifting away from significant raise cuts late in the year to a couple of small rate hikes followed by staying at the terminal rate for a while. Bonds look less appealing.
On the surface, the Canadian economy appears in balance. Inflation appears to have settled into the 4 percent to 5 percent range after declining from recent peaks. This is above the desired 2 percent level central bankers and economists seem to desire and this stickiness probably influenced the Bank’s decision. During the 1980s, 4 percent inflation rates were the norm and the economy flourished.Despite many forecasting a recession and perhaps even a serious one, Canadian GDP growth for the first quarter of 2023 came surprised forecasters, coming in at a solid 3.2 percent. The labour market is also tight in Canada. The bears have been disappointed in their forecasts but they may have been just early. Past downturns came after cyclical lows in unemployment rates and strong headline growth. Much of Europe, including Germany is in an economic downturn. The U.S. economy seems to be slowly grinding to a halt and the Canadian economy is highly dependent on the U.S.
The yield curve remains inverted and U.S. composite leading indicators are flashing a downturn. The interesting question is not about future rate increases but if and when central bankers will have to cut rates and if rates will ever return to the secular lows of 2021.
Simply put, we have scenarios and their supporters.
The first, supported by elected government officials and their amateur publicists is that there will at worst be a soft landing or minor technical recession and at best a future era of strong economic growth. They point to low unemployment, declining annual inflation, and price strength in the Canadian housing market. They are more worried about inflation than recession.
The second scenario is that we are headed for a significant recession. They expect a crash in the commercial real estate market which will result in a banking crisis. Inflation will return to below the 2 percent target rate, at least temporarily. In this situation, the central bankers will frantically cut rates, perhaps even returning rates close to zero. Obviously, this would delight government bond holders. Corporate spreads would increase dramatically.
This group points out that the Conference Board Leading Indicator Index and the yield curve are both indicating recession and those indicators have been very reliable; certainly more reliable than political leaders. Although few watch this set of data, U.S. M2 money supply is dropping at rates unseen since the Great Depression. This scenario is the most probable.
The last group feels that we are at the very beginning of an era of very high inflation. Although this might be the least probable of the three broad scenarios, it is far from impossible. Inflation forecasting is less predictable than bank economists would have you believe especially once it erupts. Furthermore, many governments in history—including the U.S. after World War II—used inflation to quickly and radically lower the debt to G.D.P. ratio. This would be absolutely devastating for bond investors.
The economic picture will be clearer in six weeks when next the Bank of Canada meets to decide its next move. It will be an interesting summer.
